Hedge Funds Offer False Hope Of Efficiency: Research Affiliates

By Teresa Rivas

There’s no denying that hedge funds have grown in popularity in recent years: Before the crisis, total assets jumped from $626 billion to $1.7 trillion in the half decade ending in 2007, and the industry now manages about $2.25 trillion.

The allure of outsize returns regardless of the market is an understandably appealing one, so it’s not surprising that investors continue to flock to these investment vehicles. But that’s not to say that hedge funds haven’t struggled to live up to these ideals: Last year was the fifth-worst on record for hedge funds, and many in the industry suspect that their peers who do beat the market are cheating.

So the question remains: Are investors buying into a good deal, or just the comforting promise of returns in a difficult environment? According to Research Affiliates, it’s the latter. The firm’s John West compiled performance for hedge funds in the past five years, using a generic portfolio of 60% stocks and 40% bonds, and the picture was a complex one:

“A pure 60/40 portfolio exhibited a Sharpe ratio of 0.29 over the five years ended December 31, 2012. Adding hedge fund of funds to a 60/40 portfolio reduces the overall return, resulting in a lower Sharpe ratio—a measure of portfolio efficiency. Upon adding a 33% exposure of hedge funds to this portfolio, the return falls from 3.8% annualized with plain 60/40 to 2.0%. This substantial decline more than offsets the favorable risk impact (standard deviation falls from 11.7% to 9.4%, a 19% decline) and the resultant Sharpe ratio falls to 0.17. Over the past five years, this category of investments, on average, has resulted in substantially lower portfolio efficiency!

“To ascertain whether this result is a fluke, we can dig a little deeper, extending the analysis back to March of 1997.The results…show a marginal positive impact on Sharpe ratios by adding hedge fund returns to the 60/40 portfolio. The improvement comes from risk reduction, as returns are still lower. Over the longer time period, adding a 33% allocation to alternative strategies would result in the same 19% reduction in risk that we found in the five-year period. We also found a similar, but smaller degradation in returns, from 6.3% to 5.8%. Because the return slippage is smaller while the risk reduction is comparable, portfolio efficiency (as measured by Sharpe ratio) improves modestly from 0.36 to 0.39. This hardly seems to measure up to the implied promise.”

So why do investors keep pouring their money into hedge funds? West surmises that it they are buying the dream of high returns, even if that is disconnected from reality. He sees much lower yields for investors than in years’ past, with a long-term return estimate of about 4% for stock and bond holders; yet rather than accept this reality, investors continue to buy what they believe are exotic, powerful funds that can return 8%, instead of more traditional products. West says that until investors confront this ‘expectation gap,’ their portfolios will continue to suffer.

His solution? Diversify away from just stocks and bonds, but not necessarily with hedge funds. “We’ve since termed this a ‘third pillar’ approach, complementing the mainstream stocks and bonds, the two pillars that dominate most investors’ portfolios. Why should the equity risk premium be the only dominant driver of our long-term success or lack thereof? Commodity futures, emerging market local currency bonds, bank loans, TIPS, high yield bonds, and REITs all have unique return drivers and will respond differently to various market environments. Shouldn’t we employ these in our asset allocation on a scale large enough to matter?”

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APRIL 19, 2013 4:31 P.M.

Marek Kotelba wrote:

> ...Shouldn’t we employ these in our asset allocation on a scale large enough to matter?
Well, so could we see some numbers on how the addition of commodity futures, emerging market local currency bonds, bank loans, TIPS, high yield bonds, and REITs benefits the Sharpe Ratio of the 60/40 portfolio?

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.

Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.